Tag: #strategy

They key chart

Trends in 12-month cumulative flows (EUR bn) presented in a stylised consolidated balance sheet format (Source: ECB; CMMP)

The key message

CMMP Analysis focuses on the implications of the relationship between the money sector and the real economy for macro policy, strategy, investment decisions and asset allocation. Monetary aggregates provide key insights into this relationship and their dynamics help us to understand the impact of monetary policy on money and the financing of the economy.

This post reviews the impact of unprecedented policy tightening by the ECB on money and financing for the euro area (EA) in 2023: what happened; why it happened; and why it matters.

Money flows fell sharply on a 12-month cumulative basis to only €18bn in 2023, down from €590bn in 2022 and €1,009bn in 2021. This dramatic contraction reflects three key factors – the rising opportunity costs of money, portfolio rebalancing and a collapse in bank lending:

1. Policy tightening increased the opportunity cost of holding money and triggered a re-allocation of overnight deposits to better-remunerated, other ST deposits. Outflows from narrow money or M1 (currency plus overnight deposits) reached €-965bn, from inflows of €23bn in 2022 and €1,018bn in 2021. Inflows to other ST deposits (M2-M1) reached €824bn, from €484bn in 2022 and outflows of €55bn in 2021. Inflows into “marketable instruments” (M3-M”) rose to €158bn in 2023, from €83bn in 2022 and €46bn in 2021.
2. The phasing out of net asset purchases and TLTROs incentivised bank bond issuance and encouraged portfolio rebalancing away from deposits to LT bank liabilities. Flows into LT liabilities rose to €345bn in 2023, from €38bn in 2022. Note that the latter do not form part of monetary aggregates, by definition.
3. Bank lending, the principal source of money creation (deposits) collapsed. Cumulative flows of lending to the private sector fell to only €40bn in 2023 (within total credit of €72bn in table above), from €624bn in 2022 and €476bn in 2021.

The contraction in narrow money during 2023, while dramatic, was neither an indicator of liquidity problems for EA banks nor a reliable indicator of economic activity or future inflation. At least not in itself. It was, instead, an example of how policy “normalisation” leads to re-adjustments in the structure and dynamics of bank balance sheets.

The collapse in financing flows to the private sector was far more serious. The pace of change of policy, policy transmission, and policy response is unprecedented and leaves the ECB and EA households and corporates without a playbook.

Dramatically reduced financing flows, historically high policy rates and increased borrowing costs are an unsustainable combination that suggest that the risk of policy errors remains very high at the start of 2024.

Money and financing the EA economy, 2023

CMMP Analysis considers the impact of the ECB’s unprecedented monetary policy on money and financing of the euro area (EA) economy from the perspective of monetary dynamics.

Recall that monetary aggregates are derived from the liabilities side of the consolidated balance sheet of monetary financial institutions (MFIs). Money is then classified according to its liquidity or degree of “moneyness” e.g. narrow money (M1, the most liquid), intermediate money (M2), and then broad money (M3), in the case of the euro area

The calculation of money supply involves adding these components together – in essence, the sum of currency in circulation plus the outstanding amount of financial instruments that have a high degree of moneyness. The simplest way to think about money, therefore, is as the short-term liabilities of the banking sector (note that longer-term liabilities are excluded from the definition of broad money as they considered portfolio instruments rather than as a means of transacting)

M3 = M1 (currency plus overnight deposits) plus M2-M1 (other ST deposits) plus M3-M2 (marketable instruments)

Money can also be calculated and understood by re-arranging the so-called “counterparts of money”, i.e. all items other than money on both sides of the consolidated balance sheet. Hence M3 in the euro area can also be calculated as:

M3 = credit to EA residents + net external assets – longer term liabilities + other counterparts

What happened in 2023 and why?

The collapse in money flows (EUR bn, 12m cumulative) to the euro area (Source: ECB; CMMP)

Money flows fell sharply on a 12-month cumulative basis to only €18bn in 2023, down from €590bn in 2022 and €1009bn in 2021 (see chart above). This dramatic contraction reflects three key factors – the rising opportunity costs of money, portfolio rebalancing and a collapse in bank lending.

The collapse in money flows (EUR bn, 12m cumulative) from a components perspective (Source: ECB; CMMP)

Policy tightening increased the opportunity cost of holding money and triggered a re-allocation of overnight deposits to better-remunerated, other ST deposits. Outflows from narrow money or M1 (currency plus overnight deposits) reached €-965bn, from inflows of €23bn in 2022 and €1018bn in 2021 (the blue columns above). Inflows to other ST deposits (M2-M1) reached €824bn, from €484bn in 2022 and outflows of €55bn in 2021 (the maroon columns above). Inflows into “marketable instruments” (M3-M”) rose to €158bn in 2023, from €83bn in 2022 and €46bn in 2021 (the green columns above).

Portfolio rebalancing and flows to LT liabilities (EUR bn, 12m cumulative) (Source: ECB; CMMP)

The phasing out of net asset purchases and TLTROs incentivised bank bond issuance and encouraged portfolio rebalancing away from deposits to LT bank liabilities (see chart above). Flows into LT liabilities rose to €345bn in 2023, from €38bn in 2022. Note that the latter do not form part of monetary aggregates, by definition.

The collapse in PS financing flows (EUR bn, 12m cumulative) to the euro area (Source: ECB; CMMP)

Bank lending, the principal source of money creation (deposits) collapsed. Cumulative flows of lending to the private sector fell to only €40bn in 2023 (within total credit of €72bn in table above), from €624bn in 2022 and €476bn in 2021 (see chart above).

Why these trends matter

The contraction in narrow money during 2023, while dramatic, was neither an indicator of liquidity problems for EA banks nor a reliable indicator of economic activity or future inflation. At least not in itself. It was, instead, an example of how policy “normalisation” leads to re-adjustments in the structure and dynamics of bank balance sheets.

The collapse in financing flows to the private sector was far more serious. The pace of change of policy, policy transmission, and policy response is unprecedented and leaves the ECB and EA households and corporates without a playbook.

Dramatically reduced financing flows, historically high policy rates and increased borrowing costs are an unsustainable combination that suggest that the risk of policy errors remains very high at the start of 2024.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

The key chart

Trends in private sector financing flows (Eur bn, 12m cum flow) and nominal NFC and HH borrowing costs (%, RHS) (Source: ECB; CMMP)

The key message

The ECB is celebrating that monetary policy transmission is working and delivering results that are EXACTLY [my emphasis] what they wanted to see. These results include:

• An increase in the cost of borrowing for EA corporates (5.26%) and households (3.91%) to their highest levels since November 2008 and June 2009 respectively
• Increases in the cost of borrowing for both sectors (343bp, 194bp) that exceed those achieved during the previous 2005-08 tightening cycle (212bp, 179bp) and that have been delivered in half the time (16 months versus 32 months)
• The highest real cost of borrowing for EA corporates (2.3%) since April 2016/September 2014
• A collapse in financing flows to the EA private sector from €764bn a year ago to repayments of €5bn now

The risks that the ECB’s celebrations might be premature are obvious, however, or at least they should be (see key chart above):

• While monetary policy transmission is working as textbooks suggest, both the pace and scale of current tightening is unprecedented
• The ECB lacks a specific playbook for such a scenario and EA economies now find themselves in uncharted territory
• Policy tightening continued even as the EA money sector was indicating increased stresses for banks, HHs and NFCs
• The end result – a combination of NEGATIVE financing flows, historic high policy rates and elevated costs of borrowing – is unlikely to be sustainable

In short, the ECB may be celebrating but the risks of policy errors remain elevated and continue to mount. The old adage, “be careful what you wish for” springs to mind…

This is exactly what we (the ECB) wanted to see

“What we are seeing is that monetary policy transmission is working. There has been a sharp increase in lending rates and a strong slowdown in loan growth. This is exactly what we wanted to see.”

Isabel Schnabel, ECB Executive Board Member, 1 December 2023

Trends in private sector financing flows (Eur bn, 12m cum flow) and nominal NFC and HH borrowing costs (%, RHS) (Source: ECB; CMMP)

In response to a 1 December 2023 interview question about the risk that the rapid drop in credit demand could exacerbate the downturn in the euro area, ECB Executive Board member, Isabel Schnabel, chose to celebrate the sharp increase in lending rates and the strong slowdown in loan growth instead. She stated that, “This is EXACTLY [my emphasis] what we wanted to see” and suggested that this proved that “monetary policy transmission is working”.

So what exactly are we/they celebrating and is there a risk that monetary policy transmission is working too well?

Trend in composite cost-of-borrowing for EA corporates (%) (Source: ECB; CMMP)

First, the composite costs-of-borrowing (CCOB) for NFCs and HHs have risen to their highest levels since November 2008 and June 2009 respectively. The CCOB for new NFC loans increased to 5.26% in October 2023, up 17bp from the previous month (5.09%). In November 2008, this cost was 5.47% (see chart above).

The CCOB for new loans to HHs for house purchases also increased to 3.91% in October 2023, up 2bp from the previous month (3.89%). This is the highest level since June 2009 (see chart below).

Trend in composite cost-of-borrowing for EA households (%) (Source: ECB; CMMP)

Second, these borrowing costs have increased more than in previous tightening cycles and in half the time. The rapid transmission of policy rates to the cost of borrowing is a key and unprecedented feature of the current ECB tightening cycle (see chart below).

Change in NFC and HH cost of borrowing since tightening began plotted against months since tightening began (Source: ECB; CMMP)

The CCOBs for NFCs and HHs have risen by 343bp and 194bp respectively in the 16 months since June 2022. Over the same time period during the 2005-08 tightening cycle, these borrowing costs rose by 133bp and 106bp respectively (see chart below). The current increases exceed the total increases that occurred during the 32 months of this previous cycle (212bp and 179bp respectively).

Trends in NFC and HH costs of borrowing (%, real terms) (Source: ECB; CMMP)

Third, the cost of NFC borrowing in real terms has reached its highest level since April 2016 and September 2014. The real cost of NFC borrowing has increased to 2.3% (see chart above). For reference, real NFC borrowing costs peaked previously at 3.1% in January 2015 and 3.7% in Juley 2009 (see graph above).

The real cost of HH borrowing has increased to 1.0%, its highest level since December 2020, but remains well below the previous, recent peaks of 3.0% in January 2015 and 4.5% in July 2009.

The collapse in financing flows to the EA private sector (Source: ECB; CMMP)

Fourth, cumulative 12-month financing flows to the private sector fell to NEGATIVE €5bn in October 2023, down from €764bn a year earlier. As noted in “Disappearing private sector financing flows – Part 1”, this represented the second consecutive month of negative financing flows, after the negative €33bn in September.

Trends in private sector financing flows (Eur bn, 12m cum flow) and real NFC and HH borrowing costs (%, RHS) (Source: ECB; CMMP)

The risks that the ECB’s celebrations might be premature are obvious, however, or at least they should be (see key chart above):

• While monetary policy transmission is working as textbooks suggest, both the pace and scale of current tightening is unprecedented
• The ECB lacks a specific playbook for such a scenario and EA economies find themselves in uncharted territory
• Policy tightening continued even as the EA money sector was indicating increasing stresses for banks, HHs and NFCs
• The end result – the current combination of NEGATIVE financing flows, historic high policy rates and elevated costs of borrowing – is unlikely to be sustainable

In short, the ECB may be celebrating but the risks of policy errors remain elevated and continue to mount. The old adage, “be careful what you wish for” springs to mind…

Please note that summary comments and charts above are abstracts from more detailed analysis that is available separately.

The key chart

Trends in financing flows (EUR bn) and nominal policy rates (%) (Source: ECB; CMMP)

The key message

The unprecedented speed of monetary policy transmission to the cost of borrowing for EA corporates and households and the subsequent collapse of private sector financing flows complicate policy options for the ECB going forward and raise the risks of policy errors considerably.

The combination of negative financing flows and policy rates that are at a historic high in nominal terms and the highest level since September 2007 in real terms is unlikely to be sustainable. This is before the pass through to the cost of borrowing for corporates and households is fully completed and taken into account.

Unfortunately, the ECB lacks a playbook for its unprecedented policy moves and their equally unprecedented consequences. EA economies also find themselves in uncharted territory. The risks of policy errors continue to mount.

Disappearing private sector financing flows – Part II

Cumulative 12-month financing flows to the EA private sector peaked at €811bn in September 2022, three months after the ECB began tightening policy rates. They turned negative in September 2023 (-€37bn) and remained negative in October 2023 too (-€5bn).

Unusually, negative financing flows coincide currently with policy rates that are high in both nominal and real terms. Current policy rates are at their highest nominal level (4.50%) since the introduction of the euro in 1999 (see key chart above). In real terms, the main policy rate is also at its highest level (1.55%) since September 2007 – albeit below April 2007’s peak real rate of 2.26% (see chart below).

Trends in financing flows (EUR bn) and real policy rates (%) (Source: ECB; CMMP)

The release of October 2023’s composite costs of borrowing for EA corporates and households is scheduled for 4 December 2023. Assuming no change from September (an unlikely assumption), the real cost of borrowing for corporates and households is relatively restrictive levels of 2.1% and 1.0% respectively already (due to the fall in inflation). This is before the full pass through to the cost of borrowing for corporates and households is taken into account (see chart below).

Trends in financing flows (EUR bn) and real NFC and HH borrowing costs (%) (Source: ECB; CMMP)

Conclusion

In short, the combination of negative financing flows and policy rates that are at a historic high in nominal terms and the highest level since September 2007 in real terms is unlikely to be sustainable.

Unfortunately, the ECB lacks a playbook for its unprecedented policy moves and their equally unprecedented consequences. EA economies also find themselves in uncharted territory. The risks of policy errors continue to mount.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

The key chart

The collapse in financing flows to the EA private sector (Source: ECB; CMMP)

The key message

Cumulative 12-month financing flows to the euro area (EA) private sector were NEGATIVE in October 2023 for the SECOND CONSECUTIVE MONTH.

• Cumulative flows to the private sector fell to NEGATIVE €5bn in October 2023, down from €764bn a year earlier
• Cumulative flows to EA corporates (NFCs) fell to NEGATIVE €41bn in October 2023, down from €388bn a year earlier (and despite a positive monthly flow of €2bn)
• Cumulative flows to the household (HH) sector slowed to €13bn from €264bn a year earlier (despite positive monthly flows in four of the past six months)
• Mortgage market dynamics are the primary driver of HH flows. Cumulative mortgage flows fell to only €16bn, down from €241bn a year earlier. In contrast, consumer credit flows have remained relatively stable at over €20bn throughout 2023

The core “choke point” message from the EA money sector remains the same.

Disappearing private sector financing flows reflect the unprecedented pace of the transmission of ECB policy to the cost of NFC and HH borrowing. They also highlight the rising risk of policy errors clearly….(see next post).

Disappearing private sector financing flows

Trends in cumulative 12-month flows (EUR bn) of loans to the EA private sector (Source: ECB; CMMP)

Cumulative 12-month financing flows to the private sector fell to NEGATIVE €5bn in October 2023, down from €764bn a year earlier (see chart above). This represents the second consecutive month of negative financing lows, after the negative €33bn in September 2023.

Trends in financing flows to the NFC sector (Source: ECB; CMMP)

Cumulative 12-month financing flows to EA corporates (NFCs) fell to NEGATIVE €41bn in October 2023, down from €388bn a year earlier and despite a positive monthly flow of €2bn (see chart above).

Trends in financing flows to the HH sector (Source: ECB; CMMP)

Cumulative 12-month financing flows to the household (HH) sector slowed to €13bn from €264bn a year earlier. This is despite positive monthly flows in four of the past six months (see chart above).

This slowdown is driven primarily by mortgage market dynamics. Cumulative mortgage flows fell to only €16bn, down from €241bn a year earlier (see chart below). Consumer credit flows have remained relatively stable at over €20bn throughout 2023, but remain below their pre-pandemic trends.

Slowdown in financing flows to the HH sector reflect mortgage market dynamics primarily (Source: ECB; CMMP)

Conclusion

The core “choke point” message from the EA money sector remains the same.

Disappearing private sector financing flows reflect the unprecedented pace of the transmission of ECB policy to the cost of NFC and HH borrowing. They also highlight the rising risk of policy errors clearly.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

The key chart

Growth trends (% YoY) in narrow money (M1) and other short term deposits (M2-M1) (Source: ECB; CMMP)

The key message

Recent events have bought renewed attention to monetary developments in the euro area (EA). One component of money supply captures the attention – narrow money or M1. The reasons are simple:

• Growth in M1 is slowing at its fastest annual rate since the creation on the EMU
• Real growth rates in M1 typically display leading indicator properties with real GDP

M1 dynamics make great headlines for sure, but they only tell one part of the current EA macro and banking story.

The rising opportunity cost of holding money, on-going portfolio rebalancing and the mechanics of money creation are important too. Together they provide critical context for understanding current EA monetary and macro developments fully:

• Opportunity cost: unprecedented ECB tightening has increased the opportunity cost of holding money and triggered a partial re-allocation of ON deposits to better-remunerated, other ST deposits (see key chart above)
• Portfolio rebalancing: the phasing out of net asset purchases and TLTROs has incentivised bond issuance and encouraged portfolio rebalancing away from deposits to LT bank liabilities, (note, the latter do not form part of monetary aggregates by definition)
• Money creation: bank lending is the principal source of money creation (deposits). Growth in private sector credit has slowed from 7.1% YoY in September 2022 to only 0.3% YoY in September 2023.

The slowdown in M1, while dramatic, is neither an indicator of liquidity problems for EA banks nor a reliable indicator of economic activity or future inflation. At least, not in itself.

Last month’s money flow data illustrates this well. Despite on-going outflows of overnight deposits, M3 (the ST liabilities of the banking system) increased by €73bn in September 2023 and bank liability flows totalled €134bn.

Policy normalisation leads to natural re-adjustments in the structure and dynamics of MFI consolidated balance sheets (see future posts). This can and does create dramatic movements in individual items and monetary variables such as M1 and increases the risk of misinterpretation.

Context is required, therefore, including full analysis and understanding of both the components and counterparts of money supply.

In short, monetary aggregates still matter. They tell us a great deal about the interaction of the banking sector and the wider economy, but they need interpreting with due care and attention…

One line captures the attention

Growth trend (% YoY) in narrow money (M1) (Source: ECB; CMMP)

Narrow money (M1) fell by -10.4% in August 2023 (a record, see chart above) and by -9.9% in September 2023, driven by sharp declines in the level of overnight deposits (-12.0% and -11.4% respectively).

Broad money growth (% YoY) and contribution breakdown by component (ppt) (Source: ECB; CMMP)

The chart above illustrates the contribution of the three components of money supply – narrow money (M1), other short-term deposits (M2), and marketable instruments (M3-M2).

With M1 contributing -7.2ppt to an overall -1.2% on broad money, it is immediately clear that other important dynamics are at play here. These include the rising opportunity cost of holding overnight deposits, on-going portfolio rebalancing and the mechanics of money creation.

Opportunity cost

Growth trend (% YoY) in other ST deposits (M2-M1) (Source: ECB; CMMP)

Unprecedented tightening by the ECB has led to a rapid increase in the opportunity cost of holding overnight deposits. This is in sharp contrast to most of the past decade. This has triggered a partial reallocation of ON deposits to better-remunerated, other ST deposits. M2-M1 has been growing by more than 20% YoY since March 2023 and grew at a record rate of 24% YoY in June 2023 (see chart above).

Portfolio rebalancing

Trends in stock (EUR bn) and annual growth rate (% YoY) of LT debt securities (Source: ECB; CMMP)

The phasing out of net asset purchases and TLTROs has incentivised the issuance of bank bonds (see chart above). This has led to a portfolio rebalancing away from deposits to longer-term liabilities that do not form part of monetary aggregates, by definition. (See “Happier times ahead for FIG DCM bankers“, August 2023.)

Mechanics of money creation

PS credit growth (% YoY) and contribution breakdown by component (ppt) (Source: ECB; CMMP)

The principal way in which bank deposits are created is through commercial banks making loans. Banks are not simply intermediaries that take in deposits and then lend them out (“loanable funds theory”). Banks create money instead. Growth in private sector credit peaked, however, in September 2022 (7.1% YoY) and has slowed to 0.3% YoY in September 2023 (see chart above).

What does this mean for monthly financing?

Monthly financing flows (EUR bn) for September 2023 (Source: ECB; CMMP)

The table above illustrates monthly financing flows to the euro area and highlights the working of these dynamics in practice.

• Outflows of M1 fell from €75bn in August 2023 to €5bn in September 2023
• At the same time, flows into M2-M1 increased from €39bn to €74bn, while flows into M3-M2 totalled €4bn
• Hence, on a net basis, flows into the ST bank liabilities (“money”) were €73bn
• Note that flows of LT liabilities also increased to €38bn in September 2023, comprising €18bn of deposits with maturity of over 2 years and €14bn of debt securities with a maturity of over two years.

Conclusion

Policy normalisation leads to natural re-adjustments in the structure and dynamics of MFI consolidated balance sheets (see future posts). This can and does create dramatic movements in individual items and monetary variables such as M1 and increases the risk of misinterpretation.

Context is required, therefore, including full analysis and understanding of both the components and counterparts of money supply.

In short, monetary aggregates still matter. They tell us a great deal about the interaction of the banking sector and the wider economy, but they need interpreting with due care and attention…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.